New Keynesian Dynamics in a Low Interest Rate Environment

Recent research has found that the dynamic properties of the New Keynesian model can be very different when the nominal interest rate is zero. Improvements in technology and reductions in the labor tax rate lower economic activity, and the size of the government purchase output multiplier can be well above one. This paper provides evidence that the focus on specifications of the New Keynesian model that produce unorthodox results in a liquidity trap may be misplaced. We show that a prototypical New Keynesian model fit to Japanese data exhibits orthodox dynamics during Japan's episode with zero interest rates. We then demonstrate that this specification is more consistent with outcomes in Japan than alternative specifications that have unorthodox properties.

The authors thank participants at the conference Frontiers in Structural Macroeconomic Modeling, the Bank of Japan, the Board of Governors, the Deutsche Bundesbank conference "Money, Finance and Banking in East Asia," the 2010 DSGE workshop, GRIPS, Keio University, Kyoto University, the 2010 SED meetings, and the Taipei International Conference on Growth, Trade, and Dynamics for their comments. They wish to particularly thank an anonymous referee, Yuichiro Waki, and Tsutomu Watanabe for their helpful comments. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.